Self-Fulfilling Financial Crises

Many mistaken assumptions about the 2008 financial crisis remain in circulation. As long as policymakers believe the crisis was rooted in the housing bubble rather than human psychology, another crisis will be inevitable.

A Crisis of Beliefs is important for three reasons. First, it offers a welcome rejoinder to those who argue that the past decade was an unavoidable result of the housing bubble in the United States. Many experts still claim that the bubble’s deflation triggered the financial crisis. But the fact is that the bubble had already deflated substantially before the crisis erupted.

J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates.

Why overthink this? Worldwide boomer retirement savings created a huge demand for assets in the early 2000s, and the poorly regulated financial sector manufactured more and more (increasingly flimsy, risky and arcane) assets to sell them, since it was (and is) in their blind best interest to do so. When creditors finally could no longer tell good assets from bad assets, they sold... and sold. The banking sector was like a mutual fund manager who keeps accepting fresh cash long after he can put it to good use, instead of closing the fund to new money. It takes courage, forbearance, brains and honesty to close a fund. Those qualities were lacking in the financial and political sectors.

For the first time I feel moved to disagree with your assessment here Brad. The behavioral approach proposed by the authors suffers from the same disease as many that have been proposed earlier. It is the idea that one particular "bias" will help to understand and explain the causes and consequences of economic crises. This seems to me to be at odds with what really goes on. Already in 1900 Poincaré criticised Bachelier because he ignored the fact that people tend to behave like sheep. People do not simply receive their information independently and then act on it and in so doing reveal that information. Herd behaviour would suggest that people's beliefs change and are strongly influenced by those with whom they interact. Thus different biases will predominate periodically, think of chartists and fundamentalists. What is more, in order for the market to be active at all there must be people on both sides so the idea that everybody shares a common bias cannot be completely true. What in fact would seem to be a reasonable explanation is that people have different biases and histories and form their expectations partly on the basis of these and partly on what they see to be the current trend. Lastly, one still has to explain why there was such a long lag between the downturn in house prices in the U.S and the collapse of the price of MBS. One possible explanation is that the information contained in the MBS was difficult to extract and people kept happily trading them believing that someone would buy them without checking, and finally this bubble burst when a few people broke away from the herd and started checking, and initiated a collapse.

`None of this suggests that there was a single simple basic psychological bias which was the key. I will spare you Krugman's quote from Mencken on that point.

It's all about over confidence in government's ability to "control" things. In this case governments created the problem via poor regulation and poor economic policy. As long as social policy leads sound economic policy in priority we'll experience more of these crisis.

The Fed had the ability to control the quality of loans issued by shadow banking and normal banking, but the Fed abdicated, Mr. Greenspan stated that there was a flaw in his world view, he admitted being wrong in believing that most financial officers would protect their assets instead of heading off the cliff for temporary profits -- he admitted that they actually needed "control", which he failed to provide. Your statement is in conflict with Greenspan's big revelation. I checked the Flow of Funds report just now, report of Jan 2009, shows that "outstanding debt" of the "domestic financial sector" (Table D.3) increased by 2.6 times between 1996 and 2008 (adjusted for inflation, and not adjusted the expansion was 3.6 times more outstanding debt). As a percentage of GDP this outstanding debt grew from 59% in 1996 to 100% in 2008. Corporate finance embraced vey high indebtedness in order to sell more loans at a higher interest rate in a bubble market. Loans skyrocketed much faster than growth or income. The word "macroprudential" was coined as a means of observing and monitoring the aggregate debt, as a result of the crisis. Government should manage the debt levels by requiring higher reserve ratios, which had fallen to 3% or something at Lehman, and by regulating he standard of loans issued. They were extremely fragile, as was the level of household debt, in the neighborhood of 120% of household income. The richest with an overabundance of capital, looked for return on capital, and went hog-wild with bad loans; second mortgages were driving consumer demand and economic growth during the bubble. It was a train wreck easily observable by a few such as Noriel Roubini , Dean Baker, Steve Keen, and so on. It resulted in 15 million job losses, 9 million permanently, and maybe 6 million foreclosures, and 10 years of poor growth due to Congressional retreat providing needed stimulus. Dodd Frank was a half-measure, and now its gone. What is next? More profit seeking with bad loans and bubbles? Corporate debt now is up 33% since 2010, not huge but perhaps troublesome, Janet Yellen says it is. Since Jan. 2009 total household net worth has doubled, from $48 trillion to over $100 trillion, capital is abundant, wages are lower than in 1964 for the 80% of labor that is nonsupervisory. The economy needs new rules that will provided workers with more income, and corporations and the wealthiest with less income. My blog: Economics Without Greed, http://benL8.blogspot.com

The market panicked because the YNHINH crowd suddenly realized that the music may have finally stopped. This is how all market panics happen. That crowd knows exactly what wretched game they have been playing, for this reason they kind of live in permanent fear and are prone to panic. This is all. Why would anyone write the whole book about this?[to the uninitiated: YNHINH is the Wall Street saying which translates into "You not here, I not here", when the consequences of runaway speculation assert themselves]

The problem in the markets then, and today, is runaway speculation fueled by the knowledge, not even a belief but a knowledge, that when the music stops most will in the end find a chair to sit on because the taxpayer will bail them out. Nothing has changed.

Financial derivatives are simply a fraudulent circular insurance scheme which gives participants a license to print counterfeit money in a form of fraudulent credit (credit which, knowingly at origination, is unlikely to be repaid). To make this work, since Wall Street lives off marginal fees, money flows needed to generate super sized profits worthy of Masters of the Universe have to be enormous, large enough to severely distort the economy.

There is a reason that we have financial crisis, but not insurance industry crisis. Insurance is regulated. State Farm cannot write "all loss" policy to Geico, with Geico reciprocating to State Farm and both liquidating their reserves to pay out bonuses to their executives because "they are both insured through their exquisite sophistication and knowledge of the markets". It is that simple, really, and it is still going on, full throttle.

The 2008 financial crisis destroyed average Americans' faith in our System and its institutions. What we thought was built on bedrock is now clearly seen to be built on quicksand.This disillusionment will be very difficult, if not impossible to repair in the human psychological realm - since we now realize that our previous belief that the System was built on bedrock was the GRAND ILLUSION.The lie has been revealed, never to be believed again!

The risk weighted capital requirements for banks guarantee: 1. Especially large exposures to what’s perceived as especially safe, against especially little capital, which dooms or bank system to especially severe crises. 2. Especially low exposures to what is perceived as risky, like loans to entrepreneurs and SMEs, which dooms our economy to weakness and not being able to reach its potential.And that has yet not even been discussed, much less learnedhttp://perkurowski.blogspot.com/2016/04/here-are-17-reasons-for-why-i-believe.html

Dr. DeLong, I would also like to add the opinion that our present regulatory practices now serve to facilitate "financial crises," even to make them profitable. (The removal of the Glass-Steagall Act in the United States also played a critical part.) Institutions know that they can be reckless gamblers, and that [the U.S.] Government[s] will "bail them out," but will not criminally prosecute them nor even compel the gamblers to lose money. Instead, "every bet is made good by Uncle Sugar" no matter how outlandish or fraudulent it was.

Lehman Brothers went bankrupt except that it effectively didn't. Securities backed by loans that could never be repaid, and lost in a Gordian Knot tangle of chains-of-ownership to the loans themselves (if they existed), were "valuable securities" nonetheless, because of the certainty of bail-out. "The securities were plainly worthless," except that Uncle Sugar would make them worth face-value, and traders knew it.

This is not a trading system – this is a casino in which Governments are repeatedly and knowingly played for the fool. Governments are imbued with power to rescue markets and people from their accidents and honest mistakes, but here these powers are being knowingly abused to facilitate financial malpractices. Society is made to bear the cost of what should be felony crimes, and the felons, never accused, go about setting up the next installment of the same cycle of crime. (JP Morgan and others have already pre-announced it.)

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